Economic slowdown will lead to rate cut

IN LITTLE more than a week the Reserve Bank will meet and decide on the cash rate leading into Christmas.

The decision will have symbolic meaning beyond the immediate technical implications of cheaper home loans or lower yields on retirement income.

If the Reserve cuts the cash rate by 0.25 percentage points - which I believe it will - the broader translation will be that 2013 is going to be a year of low confidence and low growth, which will mean lower interest rates.

As we head for the new year, some of the economic indicators that were at-trend or better are starting to slip: employment and growth foremost among them. Are they bad enough that the Reserve Bank will eventually take us below the 3 per cent cash rate?

Three per cent is the lowest cash rate since 1990: it hit 3 per cent as an emergency response in April-September 2009. Few readers would think we are nearing an emergency situation: that is, that the economy is so fragile that the cost of money has to be dropped to bargain-basement levels to create stimulus.

How bad are things that the entire market expects us to go to 3 per cent next week? It's worth looking at the evidence.

I recently argued that some of the drivers of inflation in the September quarter - gas prices, power prices, health costs - were largely government-made and the Reserve would wait until February to decide whether they were still pushing inflation or had run their course.

The core requirement of the Reserve Bank is to keep inflation within its target range of between 2 per cent and 3 per cent. And if you read the minutes of the RBA's November decision on the cash rate, the board members are expecting inflation to rise in the short term, a scenario that would suggest a rate rise, not a reduction.

However, the September consumer price index is only one element and, lately, I've been seeing other factors that suggest a rate reduction before Christmas.

First, growth. The November minutes talk about economic growth as something that was above trend at the start of the year but has slackened in the second half. The Reserve does not want to wait too long to see how far growth might come off, and is likely to reduce rates if it feels there'll be further softening of GDP in 2013.

The outlook on growth has a lot to do with our resources exports. The commodity prices of iron ore and coal have fallen because China and Japan have slowed industrial output. This not only reduces the revenue per ship load, it will also reduce the number of loads.

Because the mining industry is such a large part of our trade performance, you can expect these factors to hit our economic growth. We also have a problem with productivity, or lack of it.

Second, employment. For many quarters our unemployment stayed in a range envied by the rest of the world. However, the unemployment rate has started to rise from its 5 per cent to 5.5 per cent levels.

Some of the building approval and house price data in the second half of 2012 are slowly rising and should be fuel for some confidence, but they have not been dramatic upturns. And these sorts of measurements go directly to confidence.

Moreover, confidence has proved stubbornly low in 2012. Despite interest rates being at historic lows, house values have maintained their flat trend and housing approvals have risen slightly but have stayed low.

This week, the markets will get data on Australian capital expenditure - a very good indicator of business confidence. A poor result will almost certainly push the RBA to cut.

Of course, because we are a middle power in the economic sense, much of what the RBA has to wrestle with is regional and global. We operate in a global economy and most of our trade is regional (about 46 per cent of our exports go to China, Japan, Korea and India).

So when the Reserve sets the cash rate, it has to balance domestic factors with the international. And some of those international elements have not looked good lately. France, for instance, had its government debt downgraded by Moody's this week, and US unemployment seems fixed about 8 per cent. Also, the Chinese economy has slowed.

I predict a December rate cut of 0.25 points as an early counter-weight to slackening growth and rising unemployment. However, if the Reserve still wants to read the December CPI before committing to a rate cut, then the cut will come in February.

Whether it is December or February, I believe there is evidence of a mild slowdown in Australia's economy and the Reserve Bank will have to cut rates.